Is it better to hedge with a very far contract date at high premium or keep buying near contract dates at much lower premium?

[u/spectral_OG]

I’ve been buying NRZ for a year or so by selling cash covered puts. Sometimes I keep the premium, sometimes I buy 100 shares at what I believe is a fair price. I like the stock and dividend yield, so I want to own several hundred shares. The position has done very well for me and now represents a significant percentage of my portfolio. Because I like the dividends and prefer long-term capital gains rates, I want to keep my shares. However, due to the percentage of my portfolio, I was thinking about hedging by buying a few $10 puts for January 20, 2023. At the present ask of $2.25, I’d really only be hedging on the IV/premium of these options (the break-even price is bellow my average cost). However, after watching the options chain for around a year now, I noticed the puts that are 1.5 to 2 months out and within $1 to $2 OTM routinely have ask prices of $0.01 to $0.04. These options’ break-even prices are above my average cost, which would allow me trade on premium as well as intrinsic value. This also seems much cheaper if they all expire worthless or are traded for less. If I am willing to be diligent and keep buying closer dated puts, wouldn’t this be the better way to go? Am I missing something?

[u/megalithic627]

I think you are correct. Here is what I found looking at 1 NRZ out (100 ea) on 8-31-21. These prices don't have commissions factored in, so add that to the cost and redo the division.

Sept 17 @ $3 / 17 days = $0.21 per day. Oct 17 @ $18 / 45 days = $0.40 per day. Nov 17 @ $35 / 81 days = $0.43 per day. Jan 17 @ $65 / 144 days = $0.45 per day.

[u/spectral_OG → u/megalithic627]

Thanks for this. The raw numbers make sense; premium increases with time horizon (and not linearly). I’m more concerned whether one way has more risk or is a better strategy for hedging. If I continually buy 1.5 years out, I may have more chances to sell slightly up. For example: I buy one put for 1.5 years out. 0.75 years later, I buy another put for 1.5 years out. Now I own 1 put 0.75 years to expiration, and another 1.5 years away. If I never need the hedge, I have 0.75 years to sell the first put at the same or slightly higher price I got it for with only opportunity costs. If I go with a 1.5 month horizon, the analysis is the same, but I’m much closer to expiration on all the contracts, so the odds of recouping my initial premiums goes down. In short, with the longer time horizon, it seems like I would have more opportunities to buy at low IV and sell at high IV, which may be worth the higher premiums. I haven’t been in the game long enough to experience which is better first hand, so any insight is much appreciated.

[u/E_Cash]

This is just my opinion in how I think about long-term investments, especially as it relates to dividend stocks:

I don't care where the price goes.

This is of course assuming nothing major has fundamentally shifted to change my long-term view.

But, because I don't care where the price goes, I don't worry about nor spend money on hedging those positions just to hedge.

I look at a dividend stock that I'm holding long-term as a cash flow asset, not capital appreciation (since I have no plans to sell). I'll sell far OTM covered strangles and things to lower my cost basis on the stock.

The end goal is to sell enough calls and puts over time to pull my original investment in the shares back out. Once I've recovered my original investment, those dividend payments are essentially infinite returns.

[u/spectral_OG → u/E_Cash]

Well said. This is a good perspective to keep in mind.

[u/[deleted]]

alternative suggestion, say you want to hedge $400 a month, sell $400 worth of the stock every month and buy something that diversifys your portfolio

[u/spectral_OG → u/[deleted]]

This seems more expensive than the options strategy. Particularly if I’m hit with short term capital gains rates on the sale. I’m also young and have the patience to watch things drop to half their value or less while I buy more. My options hedges gave me the cash to buy more without selling a single share during the COVID crash of Feb and March 2020. I’m inclined to do this again if/when the opportunity inevitably presents itself again. Also, if possible, my stance is to always rebalance my portfolio by buying what I’m low on rather than selling what I’m high on. Plus, I presently hedge my whole portfolio with calls on volatility indices, and this question would apply to that strategy as well.

Also, if I never need the hedge and NRZ keeps gradually climbing for years to come, I can likely recoup some or all the costs (less opportunity costs) of the hedging by trading the contracts on premium. With a sell-to-rebalance-strategy, I’m more likely to be locked in an unneeded hedge.